CFA Level 1 Study Guide

1.
Alternative Investments: Introduction _____________________ 3
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Study Guide for the Level I 2016 CFA Exam - AllenNotes
Alternative Investments: Introduction
1. Alternative Investments:
Introduction
Learning Objectives
This summary includes a review and an analysis of the principles set forth by CFA Institute.
Upon review of this summary, you should be able to:
Juxtapose alternative investments with traditional investments .....................................pg. 5
Discuss the types of alternative investments ....................................................................pg. 6
Explain the potential benefits of incorporating alternative investments into a
portfolio .............................................................................................................................pg. 7
Discuss the fundamental characteristics of hedge funds with attention to, where
relevant, strategies, sub-categories, potential benefits and risks, fees, and due
diligence .............................................................................................................................pg. 7
Outline specific considerations with respect to the valuation and performance
measurement of hedge funds ............................................................................................pg. 7
Explain, compute, and evaluate management fees, incentive fees, and net-of-fees
returns for hedge funds ...................................................................................................pg. 14
Discuss the fundamental characteristics of private equity with attention to, where
diligence ...........................................................................................................................pg. 16
measurement of private equity ........................................................................................pg. 16
Discuss the fundamental characteristics of real estate with attention to, where
diligence ...........................................................................................................................pg. 23
measurement of real estate .............................................................................................pg. 23
Discuss the fundamental characteristics of commodities with attention to, where
diligence ...........................................................................................................................pg. 33
measurement of commodities .........................................................................................pg. 33
New Discuss the fundamental characteristics of investing in infrastructure with
attention to, where relevant, strategies, sub-categories, potential benefits and risks,
fees, and due diligence ....................................................................................................pg. 37
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New Outline specific considerations with respect to the valuation and

performance measurement of infrastructure .................................................................pg. 37
Discuss the fundamental characteristics of other alternative investments with
attention to, where relevant, strategies, sub-categories, potential benefits and risks,
fees, and due diligence ....................................................................................................pg. 38
measurement of other alternative investments ..............................................................pg. 38
Discuss risk management for alternative investments ...................................................pg. 39
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Overview
Learning Objective: Juxtapose alternative investments with traditional investments.
Alternative investments may refer to either an asset class that is an alternative to the typical
classes of stocks/bonds/cash, or to a strategy that differs from simply buying and selling
securities. For example, the largest alternative asset class is real estate; other alternative assets
include commodities (e.g., copper, corn, natural gas) and collectibles (e.g., antiques, art, stamps).
Alternative strategies may invest in ordinary asset classes, such as fixed income or equities, but
with non-traditional techniques or legal structures. Examples of alternative strategies include
hedge funds and venture capital funds. In terms of assets under management (AUM), alternative
strategies with fixed income and equities far outpace commercial real estate.
Alternative investments typically have the following features:

1. They are illiquid (one cannot quickly convert an investment to cash without loss).
2. They have low correlation with traditional asset classes.
3. Except for hedge funds, they are generally more volatile than traditional asset classes.
4. Their current market values are hard to determine (e.g., real estate valuation may rely on
appraised values rather than market values, resulting in price smoothing and understated
volatility).
5. There is not much relevant historical data regarding risk and return. Data may be subject
to survivorship bias, reporting bias, and backfill.
6. They require substantial expertise and analysis for successful investing.
7. In exchange for taking on the risk of illiquidity, the investor is compensated with an extra
return component, called a liquidity premium.
In exchange for taking on an investment lacking a good price discovery mechanism (such as a
continuously quoted national or international auction market), the investor is compensated with
another extra return component, called a segmentation premium.
Some alternative investments, such as hedge funds, have less transparency and are subject to less
stringent regulation than traditional asset classes.
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Types of Alternative Investments

Learning Objective: Discuss the types of alternative investments.
As noted above, alternative investments can be classified according to whether they are a non-
traditional asset class, a non-traditional strategy within traditional asset classes, or some
combination of the two.
Non-traditional asset classes include real estate, precious metals, commodities, and art (including
other collectibles, such as coins, stamps, antique cars, etc.). Of these, real estate is by far the
largest category, and it may include owning (directly or through a real estate investment trust - a
REIT) commercial properties (office buildings, shopping centers), storage and warehouse
facilities, apartment buildings, residential properties, farmland, or even raw land for speculation.
Real estate investments are often leveraged (that is, financed with borrowed funds) and returns
can take the form of rental payment or capital appreciation (or both). Investment in real estate
debt (mortgages), such as through a mortgage-backed security, can also be considered a type of
real estate investment.
Commodities may be invested in directly (such as buying gold and storing it in a safe deposit
box) or indirectly (such as buying shares in a fund that invests in mining firms). Investment may
also be made in futures contracts with the value of the contract dependent on the underlying
value of the commodity. Such contracts are the more common way of investing in commodities,
which would otherwise post significant challenges for transportation and storage. Few investors
would wish to directly purchase a ton of pork bellies and store them for future sale.
Art and collectibles are, however, often purchased directly and stored by the investor for later re-
sale, sometimes after restoration. Some art may be lent to museums for display, secure storage,
and restoration services where applicable.
Alternative investments may also simply be investment techniques for traditional asset classes
that differ from simply directly purchasing stocks or bonds. Hedge funds are one example. These
are private investment vehicles (usually organized as a partnership, with a limited liability
company as the general partner) that can employ a wide variety of strategies for investing in
securities, such as short-selling, use of derivatives, and significant leverage. Another example is
private equity, which involves investments in private firms or buyouts of public firms to take
them private. Venture capital is also an example of private equity. Investors in hedge funds,
venture capital, and private equity usually have high income and/or high net worth, and are
presumed to be sufficiently sophisticated to bear the potential additional risk of these
investments.
Another strategy which can be considered an alternative investment is the use of derivatives such
as options (e.g., puts, calls), futures, and swaps. Other than the use of futures in commodities
investing (mentioned above), we will not go into detail on these since they are covered in detail
in another part of the Level I readings.
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Learning Objective: Explain the potential benefits of incorporating alternative investments into a
portfolio.
The purpose of incorporating alternative investments into a traditional investment portfolio is to

increase risk-adjusted returns for the investor. Risk-adjusted returns may be improved through
two methods: higher expected returns for the alternative investment itself, and imperfect
correlation with the investors traditional asset class investments.
Higher expected returns are sought through alpha strategies - that is, value-added active
management, attempting to exploit inefficiencies in illiquid markets. Alpha strategies may
involve concentrated portfolios, market segmentation (market timing by segment), or absolute
return strategies that generate returns independent of market returns. In practice, many strategies
may simply be beta strategies - additional systematic risk through high leverage.
Imperfect correlation means that the value of the alternative investment does not move in lock
step with the traditional assets, so that overall portfolio volatility (standard deviation of returns)
should decrease after adding the alternative investment. Note, this can be true even if the
alternative investment itself is more volatile, on average, than the traditional asset classes. The
key to reduced portfolio volatility is the imperfect correlation. It is a fancy way of acting on the
adage, dont put all your eggs in one basket.
If the alternative investment also has a higher expected return than the traditional asset classes,
this will further improve risk-adjusted expected portfolio returns.
Hedge Funds
Learning Objective: Discuss the fundamental characteristics of hedge funds with attention to,
where relevant, strategies, sub-categories, potential benefits and risks, fees, and due diligence.
Learning Objective: Outline specific considerations with respect to the valuation and
performance measurement of hedge funds.
Hedge funds have gained substantial notoriety over the past decade. What are they, and how do
they work?
Hedge funds were originally developed for high net worth individual clients; however, over time,
hedge funds have diversified in their goals and structure, and as a result, attracted institutional
investors (such as foundations and endowments). It is important to note that hedge fund
investors, whether retail or institutional, must be willing to accept restrictions on redemptions
because hedge funds typically have a lock-up period during which they cannot redeem their
shares.
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Hedge Funds Defined

The very term hedge implies a defensive position against a potentially adverse outcome. One
hedges their bets, in case something goes wrong with the main plan. To an investor, the main
plan is a long position in securities markets - buy low and sell high. A hedge fund, in contrast,
would be a bet against the upward direction of markets. The simplest example would be a short
sale of stock, in which an investor would borrow stock believed to be overvalued, sell it, and
then repurchase it when the stock price dropped as expected. Upon repurchase, the stock could
be returned to the original owner, and the short seller makes a profit on the price decline.
Objectives
Today, hedge funds encompass far more than just short selling. Short selling is simply one of
many investment techniques (leverage, short selling, various forms of arbitrage, etc.) employed
by hedge funds in pursuit of a broader objective - that of achieving high absolute returns.
This objective may sound very ordinary, but it can be argued that the pursuit of high absolute
returns is really no longer that common a goal. Today, traditional equity managers are rewarded
for their performance against some benchmark index (e.g., the S&P 500). Beating the index is
their goal, but failing to keep up with the index can cost them their jobs. Consequently, stock
selection of traditional equity managers often resembles shadow indexing, in which the funds
investments are such that large deviations from the performance of the index are unlikely.
Hedge funds are not managed to narrowly beat a benchmark index; they are managed to provide
maximum absolute return, with the manager often sharing substantially (e.g., 20-25%) returns
greater than a target value.
Legal Structure
In order to achieve maximum absolute return, a hedge fund manager may need to employ large
amounts of leverage, use exotic derivatives, or take substantial amounts of short positions. To do
these things without violating securities laws, hedge funds usually take the legal form of a
limited partnership or an offshore corporation.
Registration of hedge funds and hedge fund advisers in the U.S. has evolved substantially over
the last ten years. It used to be the case that they could avoid registration with (and the rules of
the) U.S. Securities and Exchange Commission (SEC) by limiting the number of investors and
ensuring those investors met certain income or asset criteria (such as, $200,000 in average annual
income or $5 million in assets). Recent regulation, in particular the Dodd-Frank Wall Street
Reform Act, has complicated the picture somewhat.
As of 2012, hedge fund advisers with $15 million or more in assets under management must
register with the SEC; advisers with less than that may rely on state regulation. For advisers to
charge an incentive or performance-based fee, investors must be qualified clients ($750,000 in
assets under management with adviser or net worth of at least $1.5 million).
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Hedge funds with at least 500 investors must register with the SEC and are subject to quarterly
reporting requirements.
Hedge funds organized through offshore corporations (e.g., domiciled in Bermuda or the
Cayman Islands) enjoy special tax and legal advantages at the fund level. Investments can be
channeled to these offshore funds through feeder conduits that reach interested investors on the
mainland.
Hedge Fund Strategies

Hedge funds come in many types, based on their distinctive strategy; the classifications shown
below are somewhat artificial, because there may be substantial overlap in techniques employed
by a fund.
Equity Hedge Funds

Equity hedge funds typically take a bottom-up approach to taking long or short positions in
equity securities and equity derivatives (puts, calls, etc.). Some variations are:
Long-short funds typically take a mixture of long (buying) and short (selling) positions in
common stock. Some may be dedicated short funds, with mostly negative equity positions;
others may be mostly long with a few tactical short positions in stocks or bonds the manager
believes to be overvalued. Market neutral funds are hedge funds in which the long and short
positions are managed to balance each other.
Fundamental growth and value hedge funds use fundamental analysis to identify equities
offering capital appreciation or which are undervalued, respectively.
Quantitative directional funds use technical analysis (charting) to go long stocks that are
expected to rise in price and short those expected to fall.
Short bias funds focus on selling short overvalued securities. The degree of short exposure
varies.
Sector specific funds use technical or fundamental analysis to identify opportunities in a given
sector.
Relative Value Funds

Like long-short funds, relative value funds capitalize on perceived pricing discrepancies.
However, they are not limited to equity. In fact, they often involve fixed income securities, such
as fixed income arbitrage (a typical strategy: buy undervalued convertibles, sell overvalued
stock), fixed income asset-backed securities (discrepancies in the mortgage-backed or asset-
backed market), and other perceived pricing discrepancies in the fixed income market, such as
those involving spreads or volatility.
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Market-Neutral Funds
Market-neutral funds are a subset of long-short funds in which the long and short exposures
approximately balance each other out. The goal is to achieve returns in excess of the risk-free
rate by holding long investments in undervalued companies and balancing those with short
selling of overvalued companies. The fund aims to achieve returns greater than the risk-free rate,
yet have zero net market exposure (beta should be zero, due to the balance of long and short
positions).
Because the degree of over- or under-valuation can be small, leverage is often used to multiply
the perceived pricing discrepancy and the returns resulting from subsequent price movement.
Derivatives, such as index futures, may also be used to hedge broader exposures, including
exposures to bonds.
Remember, however, that hedges are rarely perfect. For example, betas do not tend to be stable,
so over time, a market-neutral portfolio may evolve into a net long position, susceptible to the
risk of an overall market decline.
Global Macro Funds

Global macro funds take positions in securities based on anticipated changes in particular
macroeconomic variables, such as the direction of a market, a currency, an interest rate, or the
value of a commodity. This is a top-down approach.
Futures funds are a type of global macro fund that take positions (long or short) on price
movements in a particular asset class (such as the euro, gold, oil, or bond futures).
Emerging-market funds take positions (long or short) on securities in emerging markets, which
tend to have less liquidity and efficiency than established markets.
Event-Driven Funds
Event-driven funds take positions on securities that have been or will be affected by a
significant event. For example, distressed securities funds often purchase at deeply discounted
prices the debt or equity shares of companies in financial trouble (e.g., bankruptcy). If the
company recovers, the fund manager can enjoy a large return. Such funds could also profit from
selling short the securities of companies that their managers believe will decline even further.
Another type of event-driven fund is one that seeks to profit from risk arbitrage in mergers and
acquisitions. Companies acquired by others often enjoy a premium on their stock price (it varies,
but often ranges from 20-35%). This is an amount paid over the normal price to induce enough
shareholders to sell out and give the buyer a controlling stake in the firm. Prior to the effective
date of merger, however, there is always a chance that a deal will fall through, either through a
failure to come to final terms, or perhaps due to objections from a regulatory body. As a result,
there is often still a small price discount remaining on the acquired companys shares
immediately prior to its acquisition. An event-driven fund can arbitrage this difference, and even
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leverage it, into a handsome profit. If the deal does fall through, however, the fund can suffer
large losses.
Another event-driven strategy is that of following shareholder activists who buy enough stock to
get representation on the board and influence in company management, strategy, and earnings
distribution policy. There are also special situations which can attract the attention of an event-
driven hedge fund manager, such as spinoffs of businesses, security issuance or retirement, etc.
Fund of Funds
A fund of funds (FOF) is an investment entity that takes money from its own investors and
channels it into other funds. When done with hedge funds, this can be a way for investors who
otherwise would not have the minimum amount to participate in hedge funds to enjoy some of
the benefits of hedge fund investing. The pooling of smaller individual amounts can achieve
economies of scale and enable investment of larger amounts in hedge funds otherwise only
available to high net worth clients.
Advantages of Fund of Funds Investing

1. Retailing: For the cost of investing in a single hedge fund, an investor can obtain
exposure to multiple hedge funds by investing in an FOF.
2. Access: An FOF can offer indirect access to a hedge fund otherwise closed due to it
reaching the maximum number of investors.
3. Diversification: An FOF offers diversification among multiple hedge funds. This reduces
the risk of a single large loss in one hedge fund, and gives investors access to multiple
strategies that, taken together, may perform well in different economic conditions.
4. Expertise: The manager of an FOF is responsible for choosing the hedge funds in which
the FOF invests. The investor should benefit from a manager that makes careful and
considered selections, using data that may be difficult for ordinary investors to obtain.
5. Due diligence: Institutions need to apply due diligence to their investments, and it can be
costly and time consuming. An institutional investor desiring to participate in a hedge
fund needs to understand the complex investment strategies that the hedge fund in
question may employ, and be aware of the risks to which it is exposed. An FOF may be
able to perform this function better and more efficiently.
Disadvantages of Fund of Funds Investing

1. Cost: Fees for the FOF are in addition to those of the actual hedge funds themselves, and
when considered together, the total cost can be large.
2. Performance: An FOF manager may select hedge funds primarily on the basis of
historically good performance; however, studies have shown that there is little
relationship between past good performance and future good results.
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3. Diversification: Just as an advantage of FOF is the reduced risk or effect of a single large
loss, it is also the case that a single large gain will be offset in part by the performance of
other funds in the FOF. Thus the FOF lowers volatility (risk) through diversification.
However, lower expected returns can be expected from lower risk investments. Also, the
high expense of hedge funds is still passed through.
Leverage and Risk in Hedge Funds

Arbitrage strategies often rely on discovering and exploiting relatively small price inefficiencies.
To earn adequate profits, a large amount of trading on these inefficiencies must be done. Often,
the amount the fund has to invest is insufficient to profitably exploit these inefficiencies. To
compensate, leverage is used to multiply the effect. Some of the ways to achieve this leverage
are:
1. borrowing funds externally, enabling more to be invested (either long or short);
2. borrowing funds through a brokerage margin account; or
3. using derivatives that only require posting of a fraction of the full notional amount as
margin.
Hedge funds face many risks that are either unique to them, or that affect them to an unusual
degree.
1. Liquidity risk: Although any investor in assets that do not trade frequently is subject to
this risk, hedge funds are especially affected by illiquidity, because many hedge fund
strategies require liquidity as a prerequisite to successfully implementing their strategies.
2. Pricing risk: Many of the assets of hedge funds are complex creations that are not quoted
continuously on a national or international auction market. Determining their value at a
given point in time can be complicated and a time-consuming task. As a result, mistakes
in pricing them can cause severe liquidity problems for hedge funds. To counter this,
hedge funds must sometimes maintain a significant position in cash, causing a drag on
fund returns.
3. Counterparty credit risk: Hedge funds must rely on broker-dealers for many large-
volume transactions, and the ability of those broker-dealers to efficiently and reliably
complete transactions is essential if the hedge fund is to successfully execute its strategy.
4. Settlement risk: Hedge funds are exposed to the risk that a party in a transaction will fail
to deliver the money or security promised on the settlement date.
5. Short squeeze risk: When the value of stocks that have been shorted rise, the owners of
that borrowed stock may demand their shares back. Hedge funds holding short positions
may be forced to close their positions at rising prices, leading to losses.
6. Financing squeeze: When any fund reaches its borrowing limit, any excess demand for
liquidity (e.g., from investors who are pulling out or prime brokers issuing a margin call)
could require the fund to close out leveraged positions (even at a loss) to raise cash.
Ideally, hedge funds should monitor their borrowing limits carefully and have
contingency plans with lenders for flexibility.
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Hedge Fund Performance

There is no single answer to the question, How have hedge funds performed historically? One
problem is that the question is too vague, because hedge funds vary so much in their strategies
and goals. Another problem is that there is not one centralized measure that tracks the
performance of all hedge funds. In fact, poorly-performing hedge funds need not even offer their
experience for inclusion in indices. Also, index data are not necessarily audited.
With those caveats, we have some general indications of how well hedge funds have performed.
A study of hedge funds from January 1990 to December 2009 showed:
1. Hedge funds tended to have higher returns than equities or bonds.
2. Hedge funds tended to have lower risk than equities, in part because of short positions
offsetting long positions.
3. Hedge funds tended to have higher Sharpe ratios (the ratio of return in excess of the risk-
free rate to the standard deviation of returns) than equities or bonds. Note, however, that
the Sharpe ratio may not be an appropriate measure for hedge funds.
4. Many (though not all) hedge funds tend to have fairly low correlation with general
equities and bonds, thus offering diversification benefits.
5. On the whole, there is low performance persistence within a hedge fund type.
Biases in Performance Measurement

Higher returns at lower risk should attract the admiration of most budding financial analysts, but
one should also cast a critical eye at these hedge fund database performance indications.
1. Self-selection bias: Recall that a given database or index does not include a hedge funds
performance unless that funds manager volunteers it. Those that perform poorly are not
likely to identify themselves, so there is a self-selection bias.
2. Instant history bias: Managers of hedge funds that perform well are likely to volunteer
their performance to be included in indices, and they will bring with them a favorable
historical record. This creates an instant history bias in the indexs historical
performance.
3. Survivorship bias in returns: Survivorship bias is also a problem. Once in an index, those
that perform well will tend to stay in the index, but those that perform badly will tend to
close operations and/or drop out. Because hedge fund managers need not adhere to
performance presentation standards, they have an incentive to only present their best-
performing funds. This would further bias index performance upward.
4. Survivorship bias in risk measures: Survivorship bias affects risk measures as well as
fund returns. Funds with poor returns and excessive risk may tend to fail and disappear
from the databases, giving the index an artificial downward bias in risk measures.
5. Smoothing of prices for illiquid assets: Many assets of hedge funds are traded
infrequently, so their market value is not known, and their price volatility is not
adequately captured. The price estimates of these assets tend to get smoothed due to
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infrequent observations and the use of estimated market values (from valuation models),
creating a downward bias in the volatility of asset prices (and thus in the volatility of the
fund).
6. Effect of option-like features on risk measures: Many hedge funds use investment
strategies that rely on option-like features, which violate assumptions underlying
traditional risk measures (e.g., portfolio returns are normally or symmetrically
distributed). As a result, the use of risk measures like standard deviation of return (found
in the Sharpe ratio) and value at risk (VAR) may lead to an understated estimate of the
probability of a large loss.
7. Fee structure and gaming: Hedge fund managers are highly compensated to take risk,
and there can be a concern that they will have an incentive to take on undue amounts of
risk to make up for any recent disappointing results. As a result, past risk measures for a
hedge fund may not correspond well to the actual risk of the fund going forward.
Hedge Fund Fee Structures

Learning Objective: Explain, compute, and evaluate management fees, incentive fees, and net-
of-fees returns for hedge funds.
Hedge fund managers receive compensation through an incentive fee structure. There is a base
management fee, often about 2% of the total assets under management. On top of that base, the
manager can earn additional fees for achieving returns in excess of a pre-determined benchmark
(a hurdle rate). For example, a manager may earn 2% plus 20% of any return over 8%. [This is
commonly referred to as a 2 and 20 fee arrangement.] If the manager achieves a 20% return on
the fund, her total management fee would then be:
2% + 20% (20% 8%) = 2% + 2.4% = 4.4%
The fund net return will then be:
20% 4.4% = 15.6%
The 8% benchmark return used above is merely illustrative. It could represent the risk-free rate,
or it could represent an average rate of return for an equity index fund (i.e., in order to enjoy
substantial profit-sharing rewards, the manager would need to prove their superiority to an
inexpensive, passively-managed equity index fund).
A fund of funds will layer on an additional fee, for example, 1% plus 10% of profit.
Hedge fund incentive fees may also be subject to a high water mark provision; this relieves
investors of paying twice for the same performance. For instance, suppose a fund valued at 100
went to 125, dropped to 100, then rose to 125 again in successive years. The high water mark
provision would prevent the fund manager from earning a performance bonus for the second
time it went from 100 to 125. Only levels above 125 would be eligible for future incentive
awards once the 125 level was first reached and incentives paid out for that.
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Example
Corbett Capital has $1 billion in assets under management at the beginning of 2012, and posts a
25% return for 2012. With a 2 and 20 incentive fee structure and a hurdle rate of 10%, what
fees will Corbett earn if the management fees are based on end-of-year values and the incentive
fee is calculated independently of it? What is the return to a Corbett investor in such a case?
Solution
Corbett finishes the year with $1.25 billion. 2% of this is $25 million. If the incentive fee is
calculated independently of the management fee, then it would be 20% of the $150 million
excess return over the hurdle rate. This is $30 million. Total fees would then be $55 million.
After fees, the fund assets under management (AUM) would fall to $1.195 billion, so the return
to investors would be 19.5% after fees.
Note, if the incentive was paid based on returns after (net of) management fees, then the
incentive fee would be 20% of ($1.250 $0.025 $1.100) billion, or $25 million. Total fees
would then be $50 million. Fund AUM would be $1.2 billion, and return to investors would be
20%.
Example
Continuing the above example, suppose the incentive fee is subject to a high-water mark as well,
and that the fund falls in value to $1.15 billion at the end of year two, then surges 30% in year 3.
Assuming incentives are paid net of management fees, find the return to investors in years two
and three.
Solution
At the beginning of year two, Corbett Capital has $1.2 billion, and the fund drops in value by the
end of year two by $50 million to reach $1.15 billion. The management fee is taken out; this will
be 2% ($23 million). There will be no incentive fee paid out, so the fund enters year three at
$1.127 billion in AUM. Year two return will be 1.127 / 1.2 1 = -6.083%.
By the end of year three, the $1.127 billion will grow 30% to $1.4651 billion. 2% of this will be
taken as management fees, or $29.302 million. The incentive fee will be based on the amount
exceeding the high water mark and the hurdle rate of 10%. The previous high water mark was
$1.2 billion from the end of year one. The hurdle rate implies that the fund needs to be at $1.32
billion before any incentive is paid out. Since the fund is above the previous high water mark, we
can use it as the base over which the performance fee is paid. So we get 1.4651 1.32
0.029302 = 0.115798, of which 20% is 0.0231596 ($ billion).
So total fees in year three will be, in millions, $29.302 + $23.1596 = $52.4616. Thus, the final
AUM for the year will be 1.4651 0.0524616 = $1.4126384 ($ billion). Returns to investors in
year three will be 1.4126384 / 1.127 1 = 25.35%.
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Due Diligence for Hedge Funds

The responsibility of an investor to exercise due diligence is not wholly passed off by investing
in a fund of funds; at the very least, the investor must then investigate the fund of funds manager,
who in turn will be responsible for selecting the hedge funds to include in the fund of funds.
Generally, however, the investor should consider several factors when considering a hedge fund
and its manager: investment strategy (if known), investment process, track record, fund size and
longevity, management factors (style, key persons, reputation, investor relations), operations
(audit, reporting), and systems factors (e.g., can they scale up?).
Private Equity
Learning Objective: Discuss the fundamental characteristics of private equity with attention to,
performance measurement of private equity.
Private equity generally refers to investments made in private companies (companies whose
shares are not listed or traded on a major exchange) or the purchase of a controlling interest in a
public company with the intention of taking it private.
The major categories of private equity are leveraged buyouts (LBOs), venture capital,
development capital, and distressed securities.
Leveraged buyouts involve acquisitions of established companies that are made with a large
amount of debt financing. The assets of the acquired company serve as collateral for the debt,
and ideally, the cash flow of the acquired company is used to service the debt. If successful, the
company becomes privately owned (if not already) and the debt becomes part of the firms
capital structure.
Venture capital refers to investments in startups and other young companies with high growth
potential.
Development capital refers to non-controlling equity investments made in established

businesses that require capital to expand, restructure, enter new markets, etc.
Distressed securities are typically debt of a mature company that is struggling financially. The
goal of the investor in distressed securities is to invest at a sharp discount and hope that the firm
improves or that gains might be obtained through bankruptcy proceedings.
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Structure and Fees of Private Equity

Like hedge funds, private equity investments are often made through partnerships, and they
charge a management fee and performance incentive, such as 2 and 20. It is important to note
that the management fee is paid on committed capital, not necessarily just invested capital. Also,
the general partner typically cannot take their incentive fee until the limited partners receive at
least the amount of their investment back. After that, they can begin to earn their 20% of profits.
Strategies: Leveraged Buyouts

One type of leveraged buyout (LBO) is the management buyout (MBO), in which the target
firms existing management arranges for financing to buy out their own firm. If, however, the
acquiring firm wishes to replace existing management and install new management, such an
LBO is referred to as a management buy-in (MBI).
Buyouts can generate very large returns for the investor, but this often has more to do with the
great amount of leverage involved rather than the unlevered returns. Because of this leverage,
such investments are risky.
The financing of leveraged buyouts is done with leveraged loans. These are usually a form of
senior secured debt which carries covenants to protect investors; for instance, the firm may be
prohibited from issuing additional debt, it may be required to maintain certain financial ratios, or
it may be prohibited from paying dividends without approval.
High-yield bonds may also finance leveraged buyouts. These are typically unsecured debt. An
alternative to high-yield bonds is mezzanine financing. Mezzanine financing may involve
convertible debt or the issuance of preferred shares with warrants attached. These would be
subordinate to both senior debt and high-yield debt.
Targets of leveraged buyouts may be firms that are undervalued in the market, ideally with a low
stock price, or inefficient companies that would benefit from a takeover and new management,
Ideally, the target firm will not already have a great deal of leverage (so more can be added to
finance the takeover). The firm should also have sustainable cash flow (to service new debt), or
valuable assets to secure collateral for the debt.
Venture Capital
There are many venture capital investments that fail for each one that succeeds. Consequently,
returns are volatile and venture capital investors require high returns to compensate for the
volatility. Once a successful venture capital investment is on firmer ground and is not at as great
a risk of failure, it typically issues stock to the general public, and the venture capital investor
liquidates their investment at that time.
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Study Session 18
Stages in Venture Capital Investing

Venture capital investing typically follows a pattern of investing stages. Though these stages are
sometimes called by different names, the purposes of the financing at the different stages are
basically the same.
Formative stage financing: Financing in the formative stage involves seed-stage and early-
stage financing.
1. Angel investing: investing small amounts, at the idea stage, to assess the marketplace
and form a business plan. Often, these investments come from friends and family of the
firm founder, through ordinary or convertible preferred shares.
2. Seed-stage financing: The stage at which capital funding is provided by a venture
capitalist to find a viable business idea through product development and market
research.
3. Early-stage financing: The stage at which capital is provided to establish facilities for
business operations, prior to actual manufacturing or sales.
Later-stage financing: Financing after the commencement of manufacturing and sales, but
before the initial offering of shares to the investing public (i.e., the firms IPO - initial public
offering). Financing at this stage typically comes through equity and convertible debt.
Mezzanine (or Bridge) financing is capital that is provided during the time between a major
expansion and the firms IPO.
Defining Characteristics of Venture Capital Investments

Venture capital investments, like real estate, differ substantially from investments in stocks,
bonds, and cash instruments. Some defining characteristics of venture capital investments
include:
1. Illiquidity: There is no quick and easy way to convert a venture capital investment to cash
without the risk of substantial loss of value. Liquidity is usually greatest following the
bridge financing stage, at the time of the firms IPO.
2. Long-term horizon required: Because of the long time period from seed-stage to IPO, and
the large risk of total loss in the intermediate stages, an investor needs a long-term
investing horizon (as well as diversification by investing in multiple venture capital
projects).
3. Market value hard to determine: Like real estate investments, venture capital investments
are unique and do not trade daily on any organized exchange. Consequently, it is difficult
to determine the investments current market value.
4. Limited historical risk and return data: Because of the lack of a centralized, continuous
market in venture capital investments, historical data on venture capital risk and return is
generally inadequate.
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5. Limited information: Estimates of expected future cash flows for projects that are little
more than a business idea are hard to make because of very limited historical or
comparable information.
6. Mismatches in management: Entrepreneurs that are talented at identifying good business
ideas may not be adequately skilled to implement the idea and manage the firm.
7. Mismatches in fund manager incentives: The venture fund manager may lack adequate
performance incentives.
8. Lack of knowledge of competitors: Often the entrepreneur and/or the analyst may not
know how many others may be working on the same business idea, how far along they
are, and how good they are. This information is harder to come by in venture capital
markets than in established markets.
9. Vintage cycles: This does not refer to old motorcycles, charming as they are. Rather, it
refers to the phenomenon that some years are better than others in venture capital.
Returns can be weak when there is an excess supply of venture capital, and when there
are too many new entrants to the market.
10. Operations expertise required: Venture capital managers are often called upon to lend
expertise and advice with respect to aspects of operations and marketing. Those that can
add value through their experience and knowledge will help their own venture capital
investments gain a competitive edge.
Performance Measurement and Valuation for Venture Capital Projects

Despite the numerous and serious investing risks, venture capital can provide investors with
much greater returns than even ordinary stock investments. However, to be successful, an
investor needs to be able to accurately value potential venture capital projects and measure
performance during the term of the investment.
Valuation
For each successful venture capital project, many projects fail before reaching the IPO stage.
When valuing a venture capital project, it is necessary to explicitly account for the probability of
failure. A venture capital project valuation also requires two other parameters:
1. the expected time at which the venture capital investment may be liquidated
2. the expected payoff to the investor at that time
Measuring Performance
Since venture capital projects have a lifespan that can range as long as several years, it is natural
to expect that venture capital managers would be interested in being able to measure
performance along the way. The typical method employed is an internal rate of return (IRR)
calculation that incorporates the cash flows that have occurred to date as well as an estimated
terminal value of any current holdings.
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Study Session 18
Accurately valuing a venture capital project is not easy, nor can there be certainty about results
obtained with thorough valuation models. Performance measurement is also fraught with
uncertainties. Some of the challenges in venture capital valuation and performance measurement
are that:
IRR calculations are heavily dependent on the uncertain terminal value of the project.
Current holdings are hard to value as there is no widely-accepted market price for them.
There may not be an appropriate benchmark on which to judge the performance of the
venture capital manager.
Effective and timely performance feedback is hard to provide given the long time needed
to determine whether an investment has been successful or not (and if it is, to what
degree).
Example
You are a venture capitalist evaluating a project that could net you $20 million on a $2 million
investment after six years. However, the project is high-risk, with the probabilities of failure in
each year shown below:
Year Probability of Failure
1 30%
2 25%
3 20%
4 15%
5 10%
6 5%
7 1%
Because of the high-risk nature of the project, you set your required rate of return to equal 20%.
Given the above data, should you invest in the project? Justify your answer.
Solution
The first step is to calculate an expected present value for the cash flows. Luckily, there is only
one cash flow that is affected by probability - the $20 million at the end of year 6. To get the
expected value of this cash flow, we must calculate the cumulative probability that it will occur.
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The probability that the project will survive until the end of the 6th year is equal to the probability
it will survive every year before that. So the cumulative probability of survival for all six years
is:
1 30% 1 25% 1 20% 1 15% 1 10% 1 5% 1 1% = 30.22%
30.22% of $20 million turns out to be $6,043,653. This is more than our initial investment
requirement, but it comes at the end of year 6. We have to discount this value back to the present
time at a 20% annual rate:
$6, 043, 653

6
= $2, 024, 007
1 + 20%
Thus, the project does have an expected payoff larger (barely) than the cost to invest, so we
would take on the project. If we did not take the project, it would be because we found
something else that would return more than 20% per year (actually 20.23% to be precise).
Exit Strategies for Private Equity

Private equity investments are intended for medium-term time horizons, approximately five
years on average, after which the investor moves on to new opportunities. Since private equity
does not trade on stock exchanges, one cannot merely call a broker and sell shares on the stock
market. Exiting the investment requires finding a new owner. Some of the common methods are:
1. Trade sale to a strategic buyer, even a competitor. This provides immediate cash and is
quicker, simpler, and cheaper to execute than an initial public offering (IPO) - and with
less required disclosure. If the buyer sees synergies with their business, the sale may be
made at a particularly high valuation. On the downside, the pool of buyers is more
limited than in an IPO, the sale may be opposed by management and employees, and the
price garnered may be less than through an IPO.
2. IPO - selling a controlling interest to the public through the stock exchanges. This may
potentially attract more buyers and a higher valuation; the sale may be structured to be
attractive to management and can generate publicity for the company. On the downside,
it is complicated, time-consuming, and expensive, with high disclosure requirements. It
may only be cost-effective for larger companies.
3. Recapitalization - allows the private equity firm to extract some value from the company
by re-leveraging. Not a true exit of investment.
4. Secondary sale - to another private equity firm.
5. Write-off/liquidation - if the investment has done poorly.
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Study Session 18
Private Equity: Diversification, Performance, and Risk

As with all alternative investments, private equity is imperfectly correlated with traditional asset
classes and thus offers diversification benefits.
The historical performance of private equity is difficult to judge because of selection bias (self-
reporting). The illiquid nature of shares, and the lack of mark-to-market valuation, leads to
smoothing of values and understated volatility. However, from what information is available, it
appears that private equity has historically outperformed general public equity, yet at the same
time, it has been more volatile. There is also some evidence of performance persistence, so
careful selection of the private equity investment firm (or manager) may prove very worthwhile.
Private Equity Valuation

Valuation of private equity usually takes one of three approaches:
1. The asset-based approach: The value of the company is determined to be the net assets
(assets liabilities), either on a going-concern basis or a liquidation basis, as appropriate.
Alternatively, one can use the replacement cost of the firms assets.
2. The comparables approach: The value of the company is determined based on a
relationship to a benchmark value. For example, if Company X is being valued, and
Company Y is a similar company that recently sold at a trailing P/E of 25, Company X
could be considered to be worth 25 times its trailing earnings (all other things being
equal, or the ratio could be adjusted). Price multiples of EBIT, EBITDA, or sales may
also be used.
3. The income approach: The value of the firm is determined to be the present value of
future economic earnings (reflecting the ability of the firm to generate free cash flows to
equity, not just accounting earnings). One could also use net income divided by an
appropriate capitalization rate.
Discounts/Premiums in Valuation of Closely-Held Firms

Understandably, illiquid shares trade at a discount to shares of comparable firms with high
liquidity. This marketability discount represents compensation for holding shares that cannot
quickly be converted to cash without significant loss.
For closely-held companies, an analyst should consider valuing the firm with a minority interest
discount (reflecting the lack of control over corporate governance), or a controlling interest
premium (for shares whose ownership includes the ability to change dividend policy, hire or
fire management, etc).
These discounts or premiums should be applied to the appropriate base. In determining the
marketability discount, the analyst should identify a highly liquid, publicly-traded company that
is comparable to the illiquid one. That comparable companys market value of equity is the base
(amount) to which the marketability discount should be applied.
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The minority interest discount should be applied to the equity value of the company if it came
with all elements of corporate control. To estimate a premium for control, the base to which the
premium would apply would be the value of equity without any control (a minority perspective).
Due Diligence for Private Equity

Before investing in private equity, an investor should understand and accept the illiquid nature of
the investment. They should carefully select a private equity firm and/or general partner with
experience and knowledge. The investor should understand the strategy and operation of the
partnership, including valuation methods, incentives, and exit strategies.
Real Estate Investment

Learning Objective: Discuss the fundamental characteristics of real estate with attention to,
performance measurement of real estate.
Real estate refers to both land and any structures built on the land. Major categories of real
estate include:
Residential - a mix of equity ownership and leverage (the mortgage loan). The loan originator
may keep the loan on their books as an asset, or sell it to be part of a securitized loan portfolio.
The loan-to-value (LTV) ratio is very important in the loan process because the property serves
as collateral for the loan.
Commercial - such as office buildings, shopping malls, apartment buildings (rentals are not
considered residential), industrial facilities, and hotels. Investors in these properties tend to be
institutions and high net worth individuals with low liquidity needs, a large amount to invest, and
a long-term time horizon.
Real Estate Investment Trusts (REITs) - Equity REITs are a form of indirect real estate
ownership. One owns shares in the REIT, which in turn owns and manages the properties to
maximize rental income. Mortgage REITs, however, invest in pools of mortgage loans and are
therefore more similar to a fixed income investment. For favorable tax treatment at the corporate
level, REITs must distribute at least 90% of their income to their shareholders annually.
Mortgage-Backed Securities (MBS) - these investment vehicles pool mortgage loans and split
principal and interest payments among tranches according to a pre-determined schedule.
Different tranches of the MBS have different priority claims on the cash flows. For instance, out
of a given pool of real estate assets, the property owners might have 25% equity, leaving 75% in
mortgage loans. The cash flows of that 75% can be used to securitize a tranched MBS, with the
lowest tranche levels backing high-yield bonds rated speculative grade, and the other tranches
backing a continuum of investment-grade mortgage-backed securities.
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Study Session 18
Timberland and farmland have low correlations with other asset classes - and other real estate
types. Timberland values are dependent on commodity price changes for lumber and land price
changes. Timberland has an advantage over farmland in that crop storage is essentially zero until
harvest. By contrast, farmland is not as flexible about harvesting - it requires regular
management and harvesting. However, it can be an inflation hedge because the value of crops
correlates with inflation.
Appeal of Real Estate

Real estate investments can also include mineral rights below the surface of the ground. Real
estate is distinguished from the traditional asset classes because it is a tangible asset - one that
you can see and touch - not just a claim of pro-rata ownership to certain cash flows (though it is
that as well).
Real estate is a popular investment for many reasons. Real estate often generates a stream of
rental or lease income, thus providing a regular source of cash flow to the investor. To the extent
rental income is adjustable, real estate rentals can provide an inflation hedge. Real estate can also
diversify a portfolio, as it provides returns that often are only modestly correlated with traditional
asset classes like stocks and bonds. The revenue streams are often comparable in amount to
bonds, and there is also the opportunity for capital appreciation.
Some say that real estate is a good investment because they arent making any more of it. This
is especially true in densely-populated developed regions, such as Europe. However, while land
area is fixed, structures on the land can often be made larger or better.
Types of Real Estate Investment

Real estate investment can use debt or equity, and can trade in public markets or private
transactions. Some major types are:
1. Free and clear equity (private, equity): This refers to the outright purchase of real
estate property, and confers full ownership rights for an indefinite period of time. The
owner may rent or resell the property as they wish. This form is also sometimes called
fee simple.
2. Leveraged equity (private, debt and equity): Real estate equity that is leveraged simply
means the real estate investor took out a loan to finance the purchase of the property.
The owner has the same ownership rights as above, but the owner also takes on debt, in
the form of a mortgage. The mortgage is the promise of the owner to transfer ownership
rights in the property to the lender if the terms of the loan are not met (i.e., if the owner
defaults in the amount or timing of required payments). The lender then can sell the
property to extinguish the debt.
3. Mortgage loans (private, debt): This is the reverse perspective of leveraged equity.
Investors in mortgage loans receive a series of cash flows from mortgage payments in
exchange for their investment. These cash flows include the debtors repayments of
principal, interest, and other servicing fees. The mortgage loan investor may end up
18-24
owning the property if the debtor defaults. During times of declining interest rates, the
investor (i.e., the lender) may experience mortgage prepayments that result in the lender
having to reinvest at lower rates. To smooth out fluctuations in the timing and severity of
these cash flows, mortgage loans are often bundled together and sold to investors, who
receive a pro-rata share of the cash flows of the entire mortgage pool.
4. Aggregation vehicles: Aggregation vehicles group together investors to achieve
economies of scale and diversification.
Real estate limited partnerships (RELPs; private, equity) aggregate investors to
fund real estate projects in a certain legal framework. The limited partners provide
capital in exchange for expected investment returns and have their liability limited to
the amount of their investment. These limited partners are coupled with general
partners, who typically have more expertise in real-estate management and who share
in the investment returns.
Commingled funds (private, debt or equity) group investors for real estate
projects, either in an open-end fund or a closed-end fund. Closed-end funds typically
buy and hold a portfolio for the duration of the fund, have a set termination date, and
do not allow new investors after inception. Open-end funds may have an indefinite
life, permit new investors, and may change the composition of the portfolio.
Real estate investment trusts (REITs; public equity) are a form of closed-end
funds that trades on the secondary market. REITs may focus on certain geographical
areas or sectors (office, mortgage, industrial, retail), and may use varying degrees of
leverage. REIT fees may be 1-2% per year, plus incentives, similar to partnerships.
Mortgage-backed securities, collateralized mortgage obligations (public, debt)
are investment pools backed by mortgage cash flows (of principal and interest) and
collateralized by the underlying property (land and structures). The cash flows are
directed by formula into tranches, with varying degrees of stability.
There are many ways in which real estate investments differ from the securities found in
traditional asset classes. For example:
1. Real estate properties cannot be moved and in a sense are indivisible. For instance, there
is only one 26th floor of the Chrysler Building in New York City. It cannot be moved,
nor can it be divided (at least not into 100 equal pieces, like a dollar).
2. Real estate properties are unique assets, so a given property can only be approximated in
its features and benefits by alternative properties.
3. The market for properties is fairly illiquid, in large part because the properties are unique,
immovable, indivisible (i.e., they are not commodities).
4. It is difficult to assess the true market value of a property because there is no national or
international auction market for them as a group.
5. Real estate investments have high transaction costs and high costs of management.
6. Government regulations may limit what an owner can do with their real estate property.
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Study Session 18
7. The market for properties is fairly inefficient, in part due to the nature of real estate and
the lack of continuously updated price information (a given property is not bought and
sold daily).
Real Estate Investment: Risk, Performance, and Diversification

Since real estate properties trade infrequently, estimates of market values are dependent upon
appraisals and pricing models. As mentioned elsewhere in this note, such models can induce a
price smoothing effect and thus understate volatility.
REIT price indices give the price performance of various publicly traded REIT companies.
However, construction of these indices may vary, so an analyst must be careful in using them.
REITs have historically had low correlations with other classes, but this can be, in part, an
artifact of REIT index construction. Some indices are based on the share price history of REITs
themselves (e.g., NAREIT), others on appraised values of properties (e.g., NCREIF). Global
REITs are much more correlated with stocks than bonds.
Generally, farmland is the least volatile in pricing and in recent years has had the best returns.
Real estate investment is sensitive to economic conditions, particularly interest rate risk, since
when interest rates are high, it is more expensive to finance a real estate purchase. Investing in a
development is risky because economic conditions may change between the time of investment
and the time of project completion. Investing in distressed properties is inherently risky. Finally,
a substantial amount of risk comes from the gain/loss magnifying effect of leverage (which, as
stated above, is necessary for most real estate investments).
Approaches to Valuing Real Estate

There are four main approaches to valuing real estate:
1. cost approach
2. sales comparison approach
3. income approach
4. discounted after-tax cash flow approach
We will look at each of these in turn.
The Cost Approach

The cost approach values real estate according to the cost to rebuild the building in its current
form. However, this approach has serious shortcomings. First, one must still value the land as
well as the building, and the cost approach does not address how to value land. Second, the
market value of a property may be quite different from its cost to reconstruct (i.e., consider
which is greater: the value of an empty office building during a recession, or the cost to rebuild
such a building).
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The Sales Comparison Approach

The sales comparison approach involves estimating the value of a property by comparing it to
recent transaction prices for sufficiently similar properties.
The sales comparison approach can be incorporated into a formal quantitative model, in a
process called hedonic price estimation. In this process, a regression is performed using
transaction prices or other measures of market value as the dependent variable. The independent
variables are the quantitative characteristics of the properties. For example, such a model for
residential homes might have as independent variables square footage, number of bathrooms and
bedrooms, size of yard, and perhaps distance to shopping or the time to commute to the
downtown office district.
Example (Simplified)
You are forming an appraisal of a house with 3,400 square feet that was built 16 years ago. You
have gathered up data on recent home price sales, and you find the following relationship
through multiple linear regression:
Characteristic Units Coefficient ($ per unit)
Square feet of house Square feet 46.58
Age of house Years -4,622.68
The intercept of the regression formula is $182,175.10. Using the sales comparison approach and
your regression values, what is the estimated value of the house?
Solution
The house value will equal $182,175.10 + 46.58 3,400 16 4,622.68 = $266,584.22.
The Income Approach

The income approach uses a simple perpetuity-type formula to estimate appraisal value. The
appraisal price is simply the net operating income (NOI) divided by an appropriate rate of
return (often called the market capitalization, or cap rate).
NOI
Appraisal price =
Market cap rate
In this formula, NOI is the net income remaining after paying operating expenses, but before
depreciation or financing cost. This would equal income less insurance, tax, utilities (if
applicable), repair and maintenance, and any vacancy or collection losses. The market cap rate is
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Study Session 18
typically set based on observed transactions on comparables (or a defined benchmark).

Rearranging the equation and changing terminology, we define:
NOI of comparable
Market cap rate =
Transaction price of comparable
Note that this method assumes that the NOI is constant and unchanging, forever. If actual
inflation differs from the inflation inherent in the market cap rate, this will cause inaccuracies
when using the simple equations above. Optimally, inflation can simply be passed through to
tenants, and not distort the model - but this is not always the case. Long-term leases may also
introduce distortions, because expenses could vary considerably during the lease term, but rental
or lease income would be fixed by contract.
Example
You are Arnold Acurah, a financial analyst using the income approach to value the Two Tonic
Towers, a ritzy apartment complex owned by the C-Gram company. You have obtained the
following data regarding Two Tonic Towers:
Yuppie Place
Two Tonic Towers (recently sold)
Gross income from rents $3,000,000
Avg. losses due to vacancy and collection problems 5%
Taxes $195,000
Insurance $55,000
Maintenance and repair $250,000
Depreciation (annual) $400,000
Interest cost (lowest available from lenders) $210,000
Net operating income Solve for this $1,150,000
Selling price $10,250,000
Using the above data, estimate the value of Two Tonic Towers.
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Solution
First we can find the market capitalization rate from that implied by Yuppie Place, a comparable
property. The capitalization rate is $1,150,000/$10,250,000 = 11.22% (rounded).
Next, we find the net operating income (NOI) for Two Tonic Towers. Noting that 5% of
$3,000,000 is $150,000, we simply find:
NOI = $3,000,000 $150,000 $195,000 $55,000 $250,000 = $2,350,000
Note that the illustrative interest cost is not a component of net operating income. Interest cost is
a financing concept, not an operating concept, and we wish our appraisal to be independent of
the financing method chosen. Neither do we subtract depreciation.
Dividing this figure by the capitalization rate (unrounded) yields an appraised value of
$20,945,656.
The Discounted After-Tax Cash Flow Approach

This is an approach used as a check against the values determined by the other methods of
valuing real estate. It recognizes that different investors are subject to different tax rates, and thus
the value of being able to deduct depreciation and interest from net operating income will vary
depending on the degree to which these items provide an investor with tax benefits.
This approach calculates the estimated cash flows from a real estate property on an after-tax
basis, and then discounts them to the present time. If the present value of the after-tax cash flows
is positive, then the property is an attractive investment.
Example
You are the financial analyst for Steve Dallas, who is currently being oppressed by a 35%
marginal income tax rate, but only has to pay 20% tax on capital gains. Mr. Dallas is considering
opening a new family theme park. The park will cost $15 million to open. With 25% paid in
cash, Mr. Dallas intends to fund the balance with a 30-year, 9.75% mortgage loan, for which the
payments are annual, the interest is tax-deductible, and depreciation will be straight-line over 30
years with no residual value. The park is expected to achieve net operating income of $2,000,000
in the first year, and that figure is expected to grow by 6% annually.
Mr. Dallas has informed you, his planner, that he requires a 15% rate of return on the project, or
it is not worth his while.
1. Calculate the after-tax cash flow for years one through seven.
2. Assume the property is sold at the end of year seven for $25 million. Selling costs are
5%. Find the revised after-tax cash flow for year seven.
3. Assuming a sale takes place at the end of year seven, calculate the theme park projects
net present value (NPV) and, in light of your clients required rate of return, make a
recommendation regarding the theme park project.
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Study Session 18
4. Assuming a sale takes place at the end of year seven, calculate an approximate yield for
the theme park project, and make a recommendation regarding the theme park project
with respect to that yield.
Solution to Part 1
After-tax cash flow = After-tax net income + Depreciation Principal repayment
After-tax net income = (NOI Interest Depreciation) 1 Income tax rate
Using a Texas Instruments BAII Plus financial calculator, we find that the payment for a 30-
year, $11,250,000 mortgage is $1,168,575:
1. [2nd] [CLR Work]
2. 30 [N]
3. 9.75 [I/Y]
4. [2nd] [I/Y] 1 [ENTER] (this sets the schedule to one payment per year)
5. 11250000 [PV]
6. 0 [FV]
7. [CPT] [PMT]
Your TI BAII Plus should show -1,168,575.276. The negative sign indicates a cash outflow. We
can also find the interest and principal payments in any year. For example, for year 1:
1. [2nd] [PV] (selects the Amortization function)
2. 1 [ENTER] (sets P1 to the first payment period)
3. [ ] 1 [ENTER] (sets P2 to the first payment period)
4. [ ] [ ] displays PRN = -71,700.27577 (this is the first period principal repayment)
5. [ ] displays INT = -1,096,875 (this is the first period interest payment)
We can check the principal repayment by noting that it is the difference between the mortgage
payment and the interest payment: $1,168,575 $1,096,875 = $71,700.
For any years principal repayment or interest payment, simply set P1 and P2 under the
amortization worksheet equal to that year (2, 3, 4, 5, 6, 7) and scroll down to get the relevant
values. To get the cumulative principal repayment or cumulative interest payments, set P1 equal
to 1 and P2 equal to the ending time period.
Depreciation will be $15,000,000/30 or $500,000 each year.
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Therefore, for year one, we get:
After-tax net income = ($2,000,000 $1,096,875 $500,000) 1 0.35 = $262,031
After-tax cash flow = $262,031 + $500,000 $71,700 = $690,331
Using the BAII Plus and the formulas shown above, we can fill out our values for after-tax cash
flow:
Year After-Tax Cash Flow
1 $690,331
2 $765,884
3 $845,879
4 $930,573
5 $1,020,237
6 $1,115,161
7 $1,215,646
Solution to Part 2
The net proceeds from selling will be 95% of $25 million, or $23,750,000. After 7 years of
depreciation, the ending book value will be $15,000,000 $3,500,000 = $11,500,000. The
difference between the net sales price and the book value is the amount of capital gain realized;
in this case, it is $12,250,000. The capital gains tax rate is 20%, so $2,450,000 in capital gains
tax is owed.
However, the after-tax cash flow is not positive, because there is an outstanding mortgage to be
paid off upon the sale. According to the BAII Plus, BAL = 10,574,969. So $12,250,000
$2,450,000 $10,574,969 = -$774,969. If a sale is made in year seven for $25 million, the
after-tax cash flow for that year will decrease to $1,215,646 $774,969 = $440,677.
Solution to Part 3
To determine the theme park projects net present value, we discount the after-tax cash flows at
the required rate of return. If the result is greater than the cost to invest in the project, we can
recommend it. Otherwise, the after-tax returns are too small to warrant recommendation.
18-31
Study Session 18
From the above data, we know that the cost to invest is 25% of $15 million, or $3,750,000.
Assuming a sale in year 7, we have the following after-tax cash flows expected:
Year After-Tax Cash Flow
1 $690,331
2 $765,884
3 $845,879
4 $930,573
5 $1,020,237
6 $1,115,161
7 $440,677
Using the BAII Plus Cash Flow worksheet, we enter these values:
1. [CF] [ ] 690331 [ENTER] (enters 690331 as C01, cash flow 1)
2. [ ] [ ] 765884 [ENTER] (enters 765884 as C02, cash flow 2). Continue through C07
3. [NPV] 15 [ENTER] (enters 15% as discount rate)
4. [ ] [CPT] (computes net present value as 3,422,663)
This net present value is less than the amount required for investment, so we recommend against
Mr. Dallas theme park project.
Solution to Part 4
The yield of the project is simply the interest rate at which the cost to invest in it equals the net
present value of its returns. Go back to the cash flow worksheet on the BAII Plus, scroll to CF0
if necessary, and:
1. -$3,750,000 [ENTER] (enters the cost to invest in the project as the initial cash outflow)
2. [IRR] [CPT] (computes the internal rate of return, or yield)
3. After several seconds, you will see IRR = 12.11179343.
Thus, the yield is approximately 12.1%, which is nearly 3% below the required rate of return.
Again, we recommend against the project. Mr. Dallas will have to find another project for his
money, or lower his required rate of return.
18-32
Investing in Commodities and Commodity Derivatives

Learning Objective: Discuss the fundamental characteristics of commodities with attention to,
performance measurement of commodities.
To this point, only once have we discussed something tangible (a thing, something you could
actually touch) - real estate. Commodities are also tangible assets.
Commodities are the raw materials of production in the real economy. They can be agricultural
goods (corn, soybeans, wheat, pork bellies), forms of energy (gasoline, heating oil, crude oil), or
metals (gold, copper, silver, aluminum).
Theoretically, investors can go buy six tons of wheat, put it in their backyard, cover it with a
really big tarp, wait for the price to go up, and sell it for a profit. They can stockpile gold in their
basement, buy new locks for the doors, and hope they can earn a handsome return on it someday.
Direct investing in commodities is not for everyone, however.
Most commodity investors prefer indirect participation in the market, rather than having to
transport and store actual commodities. Some of the ways of indirect participation in this market
are:
1. Futures contracts: This is a standardized agreement between two parties, one of which
agrees to buy a certain quantity of a specific commodity for a set price and at a given
future date from the other party, who agrees to deliver the goods and honor the contract.
Futures are traded on exchanges, marked to market daily, but are not settled with physical
delivery of the commodity (instead, taking an opposite and identical position closes out
the position).
2. Forwards, options, and swaps: Forwards are similar to futures except that they are
traded over-the-counter and thus are exposed to counterparty risk. Unlike futures,
settlement is done with delivery of the commodity. Options (when bought) grant the right
but not the obligation to buy/sell a specific amount (of commodities) by a specific time.
Swaps are agreements to exchange cash flows; usually the swap is one of fixed payments
for one that varies with commodity prices.
3. Commodity-indexed bonds: These bonds change in value according to the price of a
given commodity.
4. ETFs: Exchange-traded funds are equity investments in commodities or futures contracts
for them. Fees and expenses are even lower than mutual funds, and the market is liquid.
5. Common stock of commodity-producing companies - represents a share of ownership in
a firm - such as XOM (Exxon Mobil).
6. Managed futures - actively-managed funds with fees like a hedge fund (2 and 20), but
fairly high liquidity and low investment minimums.
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Study Session 18
7. Individually-managed accounts - by an investment manager. Can be set up like private

equity with lockup and high fees, or may be publicly available with fees at a level closer
to that of mutual funds.
The most common (and least expensive) of these indirect forms of commodity investment is
commodity futures. There are also commodity indices that track the price history of certain
commodities, and commodity index futures contracts that incorporate multiple commodity
futures prices in one index.
Commodity futures contracts are marked to market daily; the futures price should follow the
following relation:
Futures price Spot price (1 + r) + Storage costs Convenience yield,
where r is the short-term risk-free rate.
The short term interest cost (represented by r times the spot price) plus storage costs are
referred to as the cost of carry. The convenience yield is a reduction in the value of futures that
recognizes the fact that the investor does not have immediate access to the commodity for use.
If the futures price is less than the spot price, then the convenience yield is high and the forward
curve is downward sloping. Prices are said to be in backwardation.
If the futures price is higher than the spot price, the forward curve is sloped upward and the
convenience yield is near zero. Prices are said to be in contango.
Contango and backwardation are covered in more detail in the next section.
Reasons to Invest in Commodities

There are different reasons to be attracted to commodities as an asset class, depending on an
investors approach and goals. There are also different investment vehicles that would suit
different investors.
Passive Investors
Passive investors are not looking to corner the silver market or speculate on orange juice prices
in light of the latest frost report from Florida. Rather, a passive investor is more likely to be
attracted to commodities as a diversifying asset in their portfolio. Commodity prices correlate
well with inflation (+0.34, recently), whereas bonds and stocks usually erode in value with
higher inflation. So commodities, given their positive correlation with inflation, are a good
inflation hedge. They are also a good diversifier, as they have a low correlation with bond and
stock returns (0.13, 0.16, respectively).
Historical performance of commodities has been marked by high volatility. This may be due to
the fact that supply and demand can get out of balance easily, since the supply of many
commodities (especially crops) cannot be changed quickly in response to changes in demand.
18-34
Commodities have had low returns lately; they had been strong prior to the 2008 financial crisis.
However, even previously-reported high returns may have been affected by selection bias and
instant history bias in the commodity futures indices.
The most common way for passive investors to participate in the commodities market is through
a collateralized futures position or in one of the collateralized futures index funds that are
available. A collateralized futures position is created by taking a long position in futures for a
certain notional amount, and investing the same amount in government securities. For the
collateralized futures index, the sources of return come from the risk-free rate on the government
securities, plus the excess return (any return above the risk-free rate) on the futures.
Collateralized futures index funds publish both sources of return, and they assume that from
period to period, the total return is continuously reinvested, not cashed out.
Active Investors
Active investors are attracted to commodities to earn high returns from predicting the direction
of commodities prices. In times of strong economic growth, commodity prices tend to rise
because of excess demand. Thus, an active investor with confident predictions about economic
growth and inflation could make large returns through investing in commodity futures.
However, since no one can predict the future perfectly, active investors should use these good
risk management principles:
diversification
continuous monitoring of liquidity position
managing volatility in the portfolio
employing quantitative modeling techniques, such as stress tests and Value at Risk
(VAR)
leverage limits
derivatives to hedge any undesirable currency risk
careful use of models that involve data mining, out-of-sample prediction based on in-
sample performance, and performance risk adjustments for asymmetrical returns
Gold
Gold is simply a commodity, a precious metal to be precise. In its purest form, it does not rust or
tarnish, so it lasts indefinitely (unlike, say, pork bellies). It has been regarded for thousands of
years as the most reliable store of monetary value, so in a sense, it has long been a successful
universal currency. It is a highly liquid asset - one can convert it to cash quickly at relatively
small cost. Like other commodities, it has tended to be a good inflation hedge, rising in value
with price levels, even sustaining its value during periods of equity market crashes. So
historically, gold has been a good portfolio diversifier.
18-35
Study Session 18
Theoretically, however, the return on gold should be small, as its beta (under modern portfolio
theory) is close to zero or even negative. Still, it can be a risk reducer (as noted above), and its
contribution in this regard may justify the reduction expected in overall portfolio return.
The price of gold is, like most things, determined by supply and demand. Supply is fairly limited
and it cannot be produced in a laboratory; though it is still being mined, it must be extracted at a
cost. Although some gold is lost through industrial use and other forms of loss, its supply is
slowly growing. Demand is fairly predictable to those who follow trends in and forecasts for
industrial use, fashion, coin mintage, and investor orders.
Both supply and demand can be affected very dramatically by central bank acquisitions or
liquidations. Many currencies are backed by gold, as a proof of their value. The U.S. no longer
uses gold to back its currency, and some countries have had to sell much of their gold reserve to
access stronger currencies. The general trend is away from gold-backed currencies, and toward
increased liquidation of gold reserves. Governments have begun to recognize that a good credit
history and sound fiscal management are generally more useful over the long run than holding a
large store of gold in the central bank vault that may have to be liquidated in times of
hyperinflation.
Commodity-Linked Securities
Holding commodities directly is cumbersome to most investors. Direct holdings incur substantial
storage and transportation costs, the only return available is upon their sale, and usually the
return is solely from capital appreciation, not income. In addition to commodity futures, another
popular form is commodity-linked securities, which provide returns associated with commodity
prices, and sometimes provide periodic income. The main types are commodity-linked bonds and
commodity-linked equity.
Commodity-Linked Bonds
Commodity-linked bonds are simply bonds whose periodic coupon payments (and sometimes
the principal as well) are based on price changes in a given commodity or an index of
commodity prices (such as an inflation index).
Inflation-indexed government securities gained popularity in Great Britain in the 1980s. In the
1990s, the U.S. Treasury began issuing inflation-indexed securities called TIPS (Treasury
Inflation Protected Securities). Principal grows with changes in the Consumer Price Index (CPI).
The semiannual coupon is based off the principal times the real yield (the cost of borrowing),
and it too increases with inflation during the life of the bond.
Commodity-Linked Equity
Commodity-linked equity refers to a relationship between equity prices and commodity prices,
one less formalized and direct than the relationship between commodity prices and those of
commodity-linked bonds. It is more of a simple observation that the value of certain companies
equity is strongly related to certain commodity prices. For example, an oil exploration firms
18-36
value would vary substantially with the market price of oil. If oil falls in value, the cost of
extraction will outweigh the value the oil will fetch on the market. The company will not be
profitable, and the value of the firm will fall sharply.
General energy companies, however, may be diversified enough that their value is only affected
in a moderate way by commodity prices. Some firms may be well-diversified across energy
commodities (oil, gas, coal) or activities (extraction, refining, distribution, etc.), so that a spike in
one commodity price may not increase their equity value very much.
Investing in Infrastructure
New Learning Objective: Discuss the fundamental characteristics of investing in infrastructure
with attention to, where relevant, strategies, sub-categories, potential benefits and risks, fees, and
due diligence.
New Learning Objective: Outline specific considerations with respect to the valuation and
performance measurement of infrastructure.
Infrastructure assets include long-lived and capital intensive assets that provide services to the
public, or that are for public use.
Examples include:
Transportation infrastructure, such as roads, bridges, tunnels, railways, airports, seaports
Utility infrastructure, such as wastewater treatment and fresh water service, electric
power generation and distribution, natural gas distribution, and increasingly, municipal
internet service such as fiber optics networks
Public education infrastructure, such as schools and libraries
Public health & safety infrastructure, such as hospitals and prisons
In many cases, private companies develop these assets and either sell or lease them to the
government or a quasi-governmental body.
Infrastructure can be classified by type of asset or by stage of development. Infrastructure

investments that have already been built are referred to as brown-field investments, whereas
infrastructure investments which are yet to be built are referred to as green-field investments.
Investments may also be further classified according to geographical location or political
subdivision.
Form of Investment
In general, infrastructure investments may be direct or indirect. A direct investment implies that
the investor is financing and managing the entire investment themselves. This typically requires
a large capital outlay and careful attention to management and operation of the project. Such
investors are exposed to liquidity risk and concentration risk.
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Study Session 18
Indirect investment usually means that the investor pools their funds with other investors into
another company or project that makes the direct investment. Such indirect investments may be
made through purchasing equity shares (in companies that develop or manage infrastructure
assets), private equity (such as MLPs - master limited partnerships), or investment in special
infrastructure funds, including infrastructure ETFs (exchange-traded funds). Indirect investors
may enjoy higher liquidity (public equity and ETF investors, especially) and greater management
transparency for their investments, but at the price of a relative lack of control compared to direct
investors.
Risk and Benefits of Infrastructure Investments

Potential benefits include portfolio diversification through low correlation with other assets,
potential for a stable income stream (since the demand for most public infrastructure assets is
inelastic), inflation protection, and, for some institutional investors, better asset matching for
long-duration liabilities (such as pensions and life insurance). Infrastructure investments run
from low-risk/low-reward to high-risk/high-reward, depending on the nature of the investment
(direct/indirect), the type of infrastructure asset, and the details of the financing.
Risks of infrastructure investments are similar to those of other equity investments - there is
operational risk, management risk, financing risk (excessive leverage), etc. However, regulatory
risk tends to be more pronounced with infrastructure assets than with other investments, because
of the public-use nature of the asset, as well as the fact that government is often the only
customer that can buy or lease the asset being developed. Regulatory risk most often manifests
itself via operational mandates (which can be costly and/or inefficient) and pricing limitations,
but may also extend to the disposition of the asset.
Other Alternative Investments

Learning Objective: Discuss the fundamental characteristics of other alternative investments with
attention to, where relevant, strategies, sub-categories, potential benefits and risks, fees, and due
diligence.
performance measurement of other alternative investments.
Collectible items such as coins, stamps, art, antique furniture, rare books, and baseball cards can
be thought of as alternative investments as well. Their value comes purely from capital
appreciation - none of them pay dividends or coupon income.
The market for collectibles is traditionally very illiquid, even compared to other alternative
investments. However, internet search technology and automated programs for search and
monitoring have improved liquidity somewhat. Collectors no longer need to travel to major
metropolitan areas and search retailers one at a time to find a particular item or get an appraisal
of their own item. They can even monitor inventory and buy and sell opportunistically.
18-38
Collectibles require storage conditions that are safe from theft and from excesses of sunlight,
heat, and humidity.
There is a price index regularly published for the most commonly traded stamps, but for most
collectibles, values are only easily obtained from published and printed price catalogs, which can
get out of date quickly and may not be reliable for estimating what a given item would fetch in a
given location at a given time.
Like many alternative investments, the value of collectibles has a low correlation with traditional
asset classes. The return performance of collectibles is very hard to generalize, but a great deal of
their appeal is due to the fact that the investor is often also a collector. Thus, the potential for
investment returns may be, in some cases, of secondary importance.
Risk Management
Learning Objective: Discuss risk management for alternative investments.
It is particularly important to have a sound risk management process for alternative investments -
particularly for selecting the asset manager - due to the fact that alternative investments are often
illiquid, subject to long lockup periods, lack transparency, make use of derivatives and leverage,
and are exposed to counterparty risk.
Investors should pay close attention to incentives implicit in the asset managers fee structure, to
make sure the managers interests are aligned with their own.
Risk Measures
Traditional risk measures like the Sharpe Ratio may not be relevant for alternative investments
because of their illiquid nature and dependence on estimated or appraised values as proxies for
market values. As stated many times earlier in this section, estimated and appraised values tend
to be smoother than actual market values, thus understating price volatility, a key element of
traditional risk measures. Moreover, return distributions for alternative investments tend to be
negatively skewed with fat tails, which violates basic assumptions in traditional risk measures.
There are, however, other risk measures which can be useful - Value at Risk (VAR), shortfall
risk, safety-first criterion, and the Sortino ratio. These are covered elsewhere, but they tend to
have in common a focus on potential negative outcomes - their likelihood and magnitude.
Due Diligence
As stated above, manager selection is key for risk management in alternative investments. Part of
the due diligence process in selecting a manager should be to examine their track record,
expertise, their management team, resources, and incentive compensation.
18-39
Study Session 18
Ideally, the asset manager should use a third party for custody of fund assets, to reduce conflicts
of interest. There should be regular independent valuation of assets and verification of
investment results. A chief risk officer (CRO), independent of the investment process, should be
appointed and have the responsibility to establish appropriate limits on leverage, positions in any
one sector or company, and to monitor counterparty risk. An investor should think twice about
investing with a firm that lacks these safeguards.
Due Diligence Process

The typical due diligence process for investors in alternative investments includes consideration
of:
1. the organization - track record, expertise, and strength of management team
2. portfolio management process - including reliance on outside vendors for servicing
3. operations and controls - reporting and accounting, independent audit, valuation,
insurance
4. risk management - limits on leverage, positions/exposures, risk measures
5. legal - fund structure, regulations
2015 Allen Resources, Inc. All rights reserved.

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Any use of these materials without the express written consent of the publisher is a violation of federal and/or international copyright laws.
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1.

Alternative Investments: Introduction _____________________ 3

2015 Allen Resources, Inc. All rights reserved.

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New Outline specific considerations with respect to the valuation and

Alternative investments typically have the following features:

Types of Alternative Investments

The purpose of incorporating alternative investments into a traditional investment portfolio is to

Hedge Funds Defined

Hedge Fund Strategies

Equity Hedge Funds

Relative Value Funds

Global Macro Funds

Advantages of Fund of Funds Investing

Disadvantages of Fund of Funds Investing

Leverage and Risk in Hedge Funds

Hedge Fund Performance

Biases in Performance Measurement

Hedge Fund Fee Structures

2% + 20% (20% 8%) = 2% + 2.4% = 4.4%

The fund net return will then be:

20% 4.4% = 15.6%

Due Diligence for Hedge Funds

Development capital refers to non-controlling equity investments made in established

Structure and Fees of Private Equity

Strategies: Leveraged Buyouts

Stages in Venture Capital Investing

Defining Characteristics of Venture Capital Investments

Performance Measurement and Valuation for Venture Capital Projects

Year Probability of Failure

1 30% 1 25% 1 20% 1 15% 1 10% 1 5% 1 1% = 30.22%

$6, 043, 653

Exit Strategies for Private Equity

4. Secondary sale - to another private equity firm.

5. Write-off/liquidation - if the investment has done poorly.

Private Equity: Diversification, Performance, and Risk

Private Equity Valuation

Discounts/Premiums in Valuation of Closely-Held Firms

Due Diligence for Private Equity

Real Estate Investment

Appeal of Real Estate

Types of Real Estate Investment

Real Estate Investment: Risk, Performance, and Diversification

Approaches to Valuing Real Estate

The Cost Approach

The Sales Comparison Approach

Characteristic Units Coefficient ($ per unit)

Square feet of house Square feet 46.58

Age of house Years -4,622.68

The Income Approach

typically set based on observed transactions on comparables (or a defined benchmark).

Gross income from rents $3,000,000

Avg. losses due to vacancy and collection problems 5%

Maintenance and repair $250,000

Depreciation (annual) $400,000

Interest cost (lowest available from lenders) $210,000

Net operating income Solve for this $1,150,000

Selling price $10,250,000

NOI = $3,000,000 $150,000 $195,000 $55,000 $250,000 = $2,350,000

The Discounted After-Tax Cash Flow Approach

After-tax net income = (NOI Interest Depreciation) 1 Income tax rate

Depreciation will be $15,000,000/30 or $500,000 each year.

Therefore, for year one, we get:

After-tax net income = ($2,000,000 $1,096,875 $500,000) 1 0.35 = $262,031